Investing in India in 2022

Published on 08/23/22 | Saurav Sen | 4,238 Words

The BuyGist:

  • HDFC Bank – one of our long-term holdings – recently announced a merger with its benefactor/parent HDFC Limited.
  • They sound similar but they bring different sets of expertise to the table.
  • The RBI (India’s Central Bank) recently approved the merger.
  • HDFC Bank + Limited will be the largest private sector bank in India, by far.
  • In this analysis we determine whether we should keep holding on to our position in HDFC Bank considering this merger.
  • We answer the question: what do we need to believe to keep holding the stock?

Family Reunion

Our India bet has primarily been through 2 Indian banks listed on the NYSE: HDFC Bank and ICICI Bank. These are the 2 largest private sector banks that, fortunately as per script, mirrored the rising economic power in India even through a pandemic. Both bets have worked out well for us in terms of returns. However, HDFC Bank is about to begin a new chapter in their journey, which makes us question whether we want to keep holding it.

This was big news in the Indian banking sector, maybe the biggest in the last few years: A child (HDFC Bank – a Buylyst holding since 2018) proposed a takeover of its parent (HDFC Limited). Setting all the potential Bollywood drama aside, it was bound to create mass confusion at least for people writing about it. The names of the related companies are too similar. So, to avoid confusion, we’re going to create our own labels for the rest of this analysis:

  1. HDFC Bank (our holding, and the acquirer) will be called “HDB” (that’s their stock ticker on the NYSE).
  2. HDFC Limited (not our holding, and the acquiree) will be called “HDL”.
  3. The combined entity will be called “HDFCombined”.

For context, HDFC stands for Home Development Finance Corporation. The parent – HDFC Limited or HDL – is a 40+ year old company that specializes in home loans and related products. HDFC Bank or HDB (our portfolio holding) was spun off from HDL in 1994 as a private sector bank that was supposed to specialize on non-home-loan products. Well, it did.

HDB focused primarily on wholesale banking, retail banking, auto loans etc. The parent – HDL – kept the lucrative, big-ticket business of home loans. The child – HDB – took over smaller ticket loans. For nearly 30 years both companies flourished in their own spaces. Both companies clocked in double-digit loan growth over the past few years.

The merger makes practical sense – a home loans behemoth with the most successful private sector bank in the country. This is an easy argument for synergies. But price is always a question mark in these mega mergers – companies tend to overspend based on gross overestimations of said synergies. HDB did not pay much more than 1.2x book value, which any Finance Professor will tell you is a steal for a business (HDL) that clocks in 15% return-on-equity on average over the last few years. We won’t bore you with the concept of Residual Equity Valuation; be warned, they will.

In this all-stock transaction, we believe HDFC Bank (HDB) was able to engineer this merger partly because HDFC Limited (HDL) stock was under pressure over the last few years. Over the last 5 years HDL’s stock has gained just 38%. HDB’s stock (in India, not NYSE) gained 67%. This higher purchasing power had something to do with it.

In the following sections, we answer 2 main questions:

  1. Is HDB worth holding on to…?
  2. Is HDFCombined worth buying into…?

To do that, we’ve split up our analysis into 8 sections. Here’s what’s coming up:

  1. The HDFC BuyCast
  2. Story: Competitive Advantage & Moat
  3. Story: Growth Drivers
  4. Story: Thesis Busters
  5. BuyCast Sanity Check: Revenue Growth
  6. BuyCast Sanity Check: Costs
  7. BuyCast Sanity Check: Profitability
  8. Historical Cash Flow & BuyCast Details

The HDFC BuyCast

We’ve recently coined a new term: BuyCast. As with any word, we suspect someone has already used it somewhere. But until we find a better one, we’ll stick with this. So, the big idea is that we don’t forecast, we BuyCast.

BuyCasting basically means back-solving from our desired return scenario – which, for us, is 50% in less than 5 years. We back solve to something simple and tangible – annualized revenue growth we need to believe. To back solve into this rather simple measure, we obviously make some reasonable cost-structure assumptions based on a company’s historical financials.

In this case, we have the numbers for a HDB because it is a current holding in our portfolio. We’ll start with that. We’ll incorporate some HDL numbers as we go along, but we realized that we don’t need to really fill our HDFCombined number retroactively. Just HDB numbers will do. To buy into the HDFCombined story, we need to believe that HDL will not dilute HDB’s revenue growth and profitability numbers.

Here’s our HDB Buycast, which we’ll expand upon in the following sections:


Story: Competitive Advantage & Moat

HDB is the largest private sector bank in India. This wasn’t always the case – it took 3 decades of plain-vanilla banking in a tumultuous banking environment to get there. Many private and public sector banks perished in these 3 decades since India liberalized its economy. The largest bank in the country is still a state-owned behemoth, State Bank of India. But that’s a legacy of post-independence Nehruvian socialism.

When we invested in HDB back in 2018, we saw it as a relatively safe bet on the macro story in India – a young, educated population in a democratic country that’s hungry to “catch up” with China and the West in terms of standard of living. Higher incomes should translate to higher consumption, which should further translate to higher borrowing. We had expected HDB’s balance sheet will grow with the economy, given the bank’s already dominant position in the country. That’s exactly what happened despite a horrific pandemic.


While the bet looks easy in hindsight, at the time it wasn’t a slam dunk (well, nothing in investing is). That’s because the Indian banking industry was going through a rough patch – with both state-owned and private sector banks lending to the corporate sector and quasi-government institutions only to see them default without much recourse. Indian bankruptcy laws, prior to 2017-18, were archaic and not lender-friendly – a default by a borrower meant a very low probability of recovering any meaningful percentage of the loans. HDB was a lone-star private sector bank that steered clear of this banking mess. The reason was twofold:

  1. Their loan book was retail-heavy – they focused on lending to mostly salaried folks who wanted to buy a car or to farmers who needed some working capital for a few months.
  2. They didn’t “reach for yield” by lowering credit risk thresholds. Many of the other banks made loans based on relationships or government pressure because the spreads looked too appetizing. It turned out that those spreads were not enough to compensate for the default risks. HDB was much more disciplined. In former CEO Aditya Puri’s words, “we stuck to our knitting…”.

The result was that HDB maintained a benign NPL ratio – the proportion of non-performing loans (defaults) in their overall loan book was low. The NPL ratio is a common barometer for a bank’s credit risk management. Check this out:


Over time, HDB (along with ICICI – another Buylyst holding) became stars of the Indian banking industry. Even through the pandemic, they maintained their benign credit risk ratios and reasonably healthy Net Interest Margins. Many other banks saw their credit risks manifest and metastasize because of boneheaded lending decisions. Some banks even shut down. Today, the banking industry in India is going through a consolidation phase. So, the HDB + HDL merger doesn’t come as a surprise. This is good. We believe bigger is better in modern banking, and that’s both a competitive advantage and economic moat for HDB.

In the Retail sector – lending to regular folks who want to buy houses and cars – banking is now about technology and security. A big bank with a secure app is all people want for most of their needs. In India, phone-banking is very popular. Indians have been far more willing to drive the mobile-banking revolution than, say, the US. HDB has been at the forefront of that, with facilities like a "10-second loan approval" through their app. The larger a bank becomes, the more flexibility they have with products, services, and technology. At some point, a “competitive” savings rate becomes a moot point if the difference is a few basis points. People want a credit card with bells and whistles, easy loans, and a glitch-free app with great UI and UX. Nobody really wants to go to a bank branch unless it’s necessary.

New CEO Sashi Jagdishan’s argument in HDB’s latest Analyst Day was simple: It’s easier to be an experienced bank that has a reliable app rather than a tech company that’s trying to be a reliable bank. We agree with Jagdishan. HDB + HDL (HDFC), has decades of experience in lending, credit risk, and asset-liability management in a somewhat tumultuous lending environment. Google or Amazon or someone else can step in with gargantuan balance sheets, but banking will never be their base business. As big as they are, even they need to make capital allocation decisions. Lending is a capital-intensive business. It takes billions in capital to lend billions to make a few million in profit. Access to capital matters. The cost of funding matters. It helps to take in deposits instead of relying purely on equity funding, which come with much higher expectations of ROA and ROE. HDB’s cost of funding is bound to be lower than any tech company reliant on equity or bond markets.

Momentum also matters in Indian Banking today. Good credit decisions in the last 5-10 years have snowballed into more financial flexibility today. HDFC Bank (HDB) was able to initiate the merger with HDFC Limited (HDL) because of this financial flexibility. When the stock price of HDL took a beating, HDB had the funding necessary to pounce on their former benefactor. Well, we could argue this is indeed a merger of equals. They both have something unique to bring to the table. Together, they have the potential to widen their economic moat over competitors in years to come. Theoretical synergies can be realized with the right management team in place. We believe that is the case.

Story: Growth Drivers

HDFCombined would grow if the overall balance sheet grows. Volume – of deposits and loans – is the main thrust. We won’t hang our hat on growth in interest margins. Neither does HDB CEO Jagdishan – he was clear that he expects the balance sheet to double every 5 years. By American standards that looks too ambitious. But India is a different market. HDB’s numbers are proof:


The macro case – which we put forth in our original HDB thesis – still holds. We won’t repeat it here in its entirety, but a young, aspirational population in a (arguably) democratic country with a stable central banking system is basically the antithesis of China. India is still seen as “China Lite” in the eyes of many “western” investors. But to more seasoned investors in emerging markets, India is more Antifragile (to borrow the term from Nassim Nicolas Taleb). She has a British-style parliamentary democratic government (however chaotic), a relatively free media, a slowly but surely liberalizing economy, and British-style corporate governance standards. To many of them, and to us, India is more investable than China – it jives better with our preference for sleep-well-at-night investing. HDB was (and still is) a leveraged bet on the prospects of a yet-to-mature Indian Economy, assuming it maintains its conservativeness in credit risk tolerances. So far, that bet on HDB’s conservatism has paid off. And the future looks bright, at least theoretically.

The new boost of growth is merger synergy. We know that “synergy” is an overused and abused term but in this case the story seems coherent. HDL (HDFC Limited – the acquiree) is primarily a mortgage lender. HDB (HDFC Bank – the acquirer) is not – just 11% of its book is home mortgages. Despite having common names (and a common lineage), 70% of HDL borrowers don’t used HDB for their regular banking needs. It’s easy to imagine the combined HDFC offering car and home loans in one bundled package at a discount for a customer that also gets her salary directly deposited at this big bank. This type of customer is a rarity now. It doesn’t take a banking expert to see this potential synergy from a mile away.

On the cost front, HDB has lower borrowing costs – its balance sheet is mostly funded by bank deposits. HDL, however, doesn’t have a retail banking business to speak of, which forces it to borrow from the open markets. The cost synergy is, therefore, obvious albeit still theoretical. The second-order effect is that with lower funding costs, HDFCombined can offer even more competitive home loan products by offering lower rates – that’s assuming that the interest spread remains the same. So, the cost synergy should lead to revenue growth as well. Again, this is still theoretical.

Here’s how we’d summarize the rationale for the merger:

  1. HDB brings onto its balance sheet a massive, good quality home loan book from HDL, and sell those products to its CASA (current & savings account) holders.
  2. HDL’s home loan business gets access to HDB’s low-interest funding and its massive branch distribution network, thereby offering home-loan products at even more competitive rates.

Synergies are desirable but we can’t rely entirely on them in our investment thesis. In fact, we don’t. To believe in the HDB Buycast, we need to believe that the combined entity – HDFCombined – will mirror HDB’s business profile over the next 5 years:

  1. The bank’s balance sheet will grow at roughly 15% per year.
  2. Net Interest Margin will remain at roughly 4%.
  3. Gross NPL ratio will remain below 1.5%.
  4. ROE will be 15-20%.
  5. Tech investment – for mobile banking – will be more than adequate.

Getting to this profile may take a couple of years. Currently, HDL’s funding costs are high, and their Net Interest Margin (NIM) is lower than HDB’s. HDB’s management promises that HDFCombined’s ratios will converge to HDB’s ratios. But it’s difficult to time it.

Basically, the big driver is LOAN GROWTH. Every other variable needs to remain intact. Inherent in the loan growth assumption is HDB’s & HDL’s stellar reputations carrying over to HDFCombined. We’ll need to assume that size matters, reputation matters, and that, in banking, there are no prizes for jazzy experimentation. Most people want a reliable bank that has good customer service, a great app, and accessible loans. In this game, bigger is better.

Story: Thesis Busters

The scenario delineated in the previous section is not bullet proof. Several things can either impede growth or totally derail it:

  1. A housing crisis leading to a home-loans crisis, triggered by aggressive RBI (central bank) tightening…
  2. Another tech mess up by HDB…
  3. If the Deposit Insurance laws still remain inadequate....currently Deposit Insurance in India is a joke – it’s 500,000 INR or roughly $6,250 per account. Compare that to $250,000 in the US. Even adjusting for GDP per capita or Net Worth differences, Indians get a rough deal.
  4. HDFCombined needs to attract a significant number of plain-vanilla CASA (current & savings account) depositors to unlock that obvious cost synergy. Otherwise, the merger may be margin dilutive.

Indians still remember, vividly, painful banking crises because they didn’t happen that long ago. Big Banks have failed as recently as 2019. Indians are rightly reticent about keeping all their eggs in one basket, especially when only few of the eggs are insured. This is a growth constraint for banks like HDB that want to impose their size and scale to dominate the market. If they want rapid loan growth, they need to attract plain-vanilla deposits.

Sanity Check: Revenue Growth

It’s hard to model the entire cash flow waterfall of the combined entity – HDFCombined – because the businesses are different enough that a retroactive creation of financials by analysts like us is futile. Our BuyCast – revenue growth that we need to believe – is based on just HDB’s numbers. However, we need HDL to carry its weight – we just need it to NOT dilute HDB’s BuyCast. This is how our BuyCast stacks up against historical numbers:


CEO Jagdishan believes that balance sheet growth (not spreads) will be the primary driver of revenue growth. This is how the two companies – HDB and HDL – have done so far:


The way to read the charts above is that if profitability ratios of HDFCombined roughly mirror HDB’s profitability ratios (like NIM, ROA, ROE), then historical loan growth of both companies give us a good indication of what’s to come. That assumes that CEO Jagdishan is right about his macro thesis. It also assumes that HDB’s reputation momentum will remain intact.

We found this interesting macro chart in HDL’s last earnings call. They make a strong case for a potential upswing in mortgage demand. However, it’s hard for us to model how sensitive loan growth will be to rising interest rates. This paints a compelling picture of Jagdishan’s argument:


Sanity Check: Costs

One of metrics that analysts (and banks) track is the Cost to Income ratio. Here’s how it has tracked so far for both HDB and HDL.


This was surprising to us – HDL’s cost-to-income ratio is a lot lower than HDB’s. This is a good thing – HDL’s operating margins should be additive to HDB’s if things remain as is. We suspect that HDL’s margins are higher because they don’t need to have the branch network and sales staff that HDB needs to have to attract deposits. The point is that we expect HDB’s operating margins to stay consistent. We don’t need to factor in any significant cost synergies. Here’s what we factored in our BuyCast for HDBs Operating Costs:


Sanity Check: Profitability

We can only really believe the Buycast if HDB squeezes out the same level of profitability from its expanding loan book. Here are 2 popular measures of profitability tracked by both analysts and management: NIM and ROE.

We expect Net Interest Margin (NIM) ratios to remain around the 4% range for the combined entity. We noticed that HDL’s NIM ratios are generally lower than HDB’s. There could be some dilutive effects here in the short term. But here’s where we may need to factor in some synergies. HDB’s cost of funding is much lower than HDL’s. If HDL has access to some of HDB’s cheaper sources of funds (like bank deposits), HDL’s NIM should increase. We’ll need to believe that HDL’s NIM will catch up to HDB’s.

On ROE, which many analysts believe is the true measure of bank profitability, both companies register consistently high numbers – between 15-20% (not counting the pandemic), which is what HDB CEO Jagdishan expects HDFCombined to deliver. This measure doesn’t require us to believe in any synergies.


Historical Cash Flow & BuyCast Details

Here’s an important point about the numbers below: Banks report financials differently because their business is peculiar. Essentially, they make money by borrowing money at lower interest rates and lending at higher rates. So, they report numbers differently compared to most companies that sell tangible products or services. But to keep things consistent with our other investment theses, we’ve rearranged HDB’s numbers. We’ve made 2 main alterations:

  1. Convert HDB’s numbers to our usual cash flow waterfall as much as possible – from revenue to free cash flow.
  2. Used a fixed exchange rate of 88 INR/USD – retroactively – to put things on a level playing field. Currently, the exchange rate is about 80 INR/USD. So, we added 10%.

The last column – The Buycast – is not a forecast. It’s a BUYCAST. It’s “what needs to happen” in the underlying business for us to consider buying the stock. For all the reasons mentioned in the sections above, this Buycast looks believable, even probable.

We are rationally exuberant about HDB + HDL = HDFCombined. We will continue to hold HDB at 3% of our portfolio, at least until next week when we dig into its rival ICICI Bank. HDB stockholders will own 51% of HDFCombined once the merger is fully consummated. We believe it’s a good idea to stick around.

Here are the cash flow historicals and assumptions:




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